The details of my Big Bet against Krispy Kreme

[DesertCat]

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DC,

What is your take on Al Kharafi & Sons? Some are worried about what this means for the shorts.

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I think they are just opportunistic. It looks like they took an equity position just before the announcement of the awarding of their franchise rights, perhaps because they thought it would help them get those rights, or perhaps they thought the stock would pop and they could make a quick profitable trade. It will be interesting to see if they sell their position.

But that franchise deal doesn't help KKD in the short run, and probably doesn't help much in the long run. First, it doesn't appear they paid anything to KKD for it. So KKD has to wait until their franchises are up and running before it gives them new cash flow. And franchise fees are so small, they have to open many stores before it's significant, that will take years. Lastly, they probably can't buy ingredients from KKD due to distance, which would mean they aren't contributing to KKD's most profitable segment.

Where Al Kharafi & Sons could really hurt the shorts is to make an equity investment in KKD, or buy the existing debt. That would eliminate bankruptcy as a possibility. But some issues with this.

1) If you are willing to invest in KKD's equity, why buy on the open market. Why not put that money directly into KKD's balance sheet via a private placement?
2) KKD might be restricted from issuing new shares while it's SEC filings are out of date.
3) Right now Al Kharafi's exposure is small, probably less than $40M total. To help KKD they'd have to invest a pretty significant amount, mostly likely $100M-$300M. Big change in commitment, and not so small, even for them.

My guess is they'd want to at least knock out that debt ($135M or so), which has to be very costly right now. Assume KKD gives them a small discount, say $8 per share, for 17.5M shares ( $140M). No more bankruptcy worries, but company still has the following problems

1) Shareholder, SEC suits of a possibly very large liability.
2) Broken business model.
3) Declining sales.
4) Share count goes from 60M to 77.5M for only $120M, if they decide to invest $200-$300M shareholders get creamed by dilution.

To fix the business model they'd want the new CEO to test several new store concepts, pick a winner, then roll it out through all of the stores. That could easily take $200M+ (because many stores are just too big and have to be closed and re-opened in smaller locations). Does Al Kharafi want to pay for that?

And I can't believe any large investor would want to get deeply involved without having a large measure of control, and some certainty that there is a real turnaround plan i.e. a new store model that actually works. Buying the debt might be one route, because the debt has a lien on all the assets of KKD. Al Kharafi could provide some payment relief etc, but still maintain an iron fist to protect it's interests. But even then, someone still has to ante up to fix the business model.

So to sum up. Yes, Al Kharafi or any other deep pocketed investor could fix all of KKD's immediate liquidity problems, and invest enough to give them a chance to fix their long term problems. But I believe that it's extremely difficult (if not against the rules) to sell new equity given the current state of their financials. And if it's possible, I think any reasonable investor is going to demand a large control position, and special rights (preferred stock, warrants?) ahead of and heavily diluting existing shareholders.

If it happens, shareholders might get excited, and the market may take KKD up to new heights. Or it might tank when the shareholders realizes how diluted their position will be. Since I think it's unlikely to happen, I don't worry to much about the consequences, I'll just have to evaluate the situation when, if ever, it occurs.

[FortFun]

I have been following this thread loosely and find it very interesting, since I am young and not involved in the stock market at all. What is the latest status of Krispy Kreme and what are all of your options looking like right now?

[DesertCat]

KKD has bounced into the low 8s a couple times and my newer ITM (in the money) options at times have almost been profitable enough to cover my losses in my older OTM options. The lesson so far is that I was initially too greedy in buying options that would only pay off in bankruptcy. Essentially my OTM bets only pay off in a bankrtuptcy scenario but they pay around 10-1, my ITM bets pay around 3 or 4-1 in a bankruptcy scenario, but also pay off if KKD just drops in price.

Recent news is that KKD announced they got paid by KKD australia (around $3M), which helps their liquidity situation and wasn't good news for me. But the big news should be out late this week, they'll file a NT-10Q with the SEC that should layout their liquidity and sales figures. We'll see how bad things are and how the market reacts.

[gmandan]

NT-10Q filed here:

http://yahoo.brand.edgar-online.com/...&Type=HTML

Sales about $116 million for the quarter, a 17% decrease from last year. No liquidity update and it's getting hit in AH.

[Jcrew]

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The lesson so far is that I was initially too greedy in buying options that would only pay off in bankruptcy.

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That is very result oriented thinking.

[gmandan]

Oops, rushed through it too quickly. Revenue is down to $116M and "systemwide sales" down about 17%.

"Systemwide sales data include sales at all Company and franchise locations. Systemwide sales is a non-GAAP financial measure; however, the Company believes systemwide sales information is useful in assessing the overall performance of the Krispy Kreme brand and, ultimately, the performance of the Company."

[buffett]

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That is very result oriented thinking.

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I think it's great to be aware of this bias in self-analysis and it's always a good idea to consider it in a postmortem, and DCat may disagree with me here, but I don't think this is ROT. I think another way to say what DCat seems to be saying is that he assigned too high a probability to the bankrupt-within-x-months scenario. My take is that he used the "too greedy" phrase as more of a self-deprecating jab.

[DesertCat]

Buffett is right. I wanted a huge (10x) return so I bought options that would pay out 10x in BR, while taking the risk they'd expire worthless in almost any other scenario. While I think the odds of bankruptcy are better than 10% or so, making this a +EV bet, the ITM options have very nice payouts in BR, but also retain value the majority of the scenarios. So essentially, the ITMs are like a +EV coinflip that pays some random amount between 1x and 5x your bet. That's much better and has much lower variance than 10-1 on a 15-20% event.

As far as the report goes, the sales weren't down as far as I had hoped, and their same stores sales language was confusing, but if I read it right seems to indicate that company owned same store sales have rebounded somewhat. They are still a long way from being a profitable business IMHO. They should issue a separate 8k with liquidity in the next day which will let us know if they are close to a BR filing or not.

[Jcrew]

It is very hard to discern whether his probability distribution was off or that he was unlucky. But I do agree that he was overly optimistic of the timeline. There are always financial tricks companies can do to keep on going.

[TimM]

I don't think it was just an ITM/OTM problem, but also a time to expiration problem. They may wind up bankrupt after all, but it might take some time.

After reading your analysis, and seeing how weak the chart looked, I bought some NOV 10 puts which are doing well. So good luck to us both. [img]/images/graemlins/smile.gif[/img]